Exercise 11.1:
What is 'insider trading' and why is it sometimes illegal or Why did Martha go to jail?

The Securities and Exchange Commission (or SEC) is the government agency tasked with investigating insider trading. According to the SEC, insider trading is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

Savers and their financial advisors try to buy the financial investments with the highest possible returns. This directs funds into the uses that are most likely to be productive. Information is crucial at both the micro level (for individual investors) and the macro level (the economy as a whole) for making decisions that lead to an efficient allocation of resources. People who have insider information and use the information to illegally trade stock in their company have an unfair advantage over those who do not have the inside information.

If an individual has access to information available only to those inside a company, he or she can use that information to profitably buy or sell the company's stock. For example, if the person knows about an upcoming change that will increase the company's profits, the person can buy the company's stock and gain a high return when the stock price goes up after the information becomes available to the public. Conversely, a person with access to negative information about a company can sell their company stock before the price falls in response to the negative news becoming public.

Insider information applies not only to individuals with access to non-public company information, but to those who the person may give a "tip" about the information. It is also illegal for a person who has been "tipped" about insider information to trade a stock based on that information. Martha Stewart was convicted of lying to the SEC about receiving insider information about an imminent decline in Imclone stock values and selling her Imclone stock before the stock price fell.

References:

http://www.sec.gov/answers/insider.htm